Teece’s 1986 article in Research Policy is surprisingly little known among economists given that it has been cited something like 10,000 times. I want to give an interpretation of the article similar to that of Sid Winter in his article written on the 20th anniversary of the original.
Schumpeter famously argued that “perfect” competition is, in fact, not so, as the lack of rents given no incentive for firms to spend on R&D, and since growth is so much important for welfare than static inefficiency, we ought be more forgiving of market power. Ken Arrow, in a well-known article from the 1962 NBER Invention volume, maintains that Schumpeter’s logic is incomplete, and that with patent licensing, monopolies can make things worse. Consider a good with marginal cost 2 and demand such that Q=6-p. In the competitive market, price is 2, quantity is 4, and industry profits are zero. With a monopoly, price is 4, quantity is 2, and industry profits are 4. An innovator invents a technique that lowers marginal cost for the good to 1. In the competitive market, he can license this good to all producers, accruing licensing profits of 1×4=4. In the monopoly market, the monopoly with marginal cost of 1 would optimally sell 2.5 units at 3.5 each, earning 2.5×2.5=6.25. Therefore, the invention increases monopoly profit by 6.25-4=2.25, and the inventor can earn no more than 2.25 by licensing to the monopolist. It seems, then, that whether monopoly or perfect competition leads to more invention depends, at least in part, on the ability of inventors to license without being appropriated.
Teece takes that logic a step further. As most inventions can be appropriated, either by direct imitation, or by inventing around the relevant patent, inventions will only pay off for the inventor if she owns the best complementary assets. Consider the case of EMI’s CAT scanner and Searle’s Nutrasweet. The CAT scanner was both invented and commercialized by EMI, leading to a Nobel for one of EMI’s engineers. Nonetheless, EMI would be out of business within a few years, while competitors made bundles of money from similar scanners. Nutrasweet, on the other hand, was enormously profitable for Searle. Why the difference?
The difference is access, through contracting or ownership, to complementary assets. EMI’s imitators had much better medical technology manufacturing and distribution technology than EMI itself. Searle, on the other hand, took deliberate steps to protect itself once its patent ran out, by establishing a strong brand during the patent period, by limiting outside manufacturing (since those contract manufacturers are potential future competitors), and by doing R&D on a product that is difficult to imitate without violating patent; for one, other alternative sugars would need to go through their own FDA approval, which takes years. Teece’s article also provides a second reason why large firms spend more on R&D. It’s not just that they will have market power in the product’s market, but also that they are more likely to own complementary assets.
Final Research Policy version (IDEAS version). A site note: this is the 300th article we’ve discussed on this site. I would love to see more focused research blogs. There are a few (e.g., the NEP-HIS blog with a weekly post on economic history), but that’s it. I’d be glad to share my experience from this blog with anyone interested. For one, the potential audience for discussions of new research is huge – at least half of the readers of this site are non-academics, but instead represent the curious, people working in the tech sector, undergraduate students, etc.